Depreciation in business interruption insurance — A misunderstood concept

Depreciation per se is neither a fixed cost nor a variable cost. In essence, depreciation is an optional cost, insurable as an item of the policy, at the sole discretion of the proposer/insured.

Main stream insurance practitioners would be horrified to regard depreciation other than a fixed cost because many, if not all, have been programmed to believe, like their predecessors, including those living in a bubble, the mantra that depreciation is part of the standing charges.

The prerogative to insure depreciation, or not, as an optional cost rests with the proposer/insured. Depreciation can be insured as an item on a limit of liability basis much like, inter alia, Additional Increase in Cost of Working and accountants’ charges/fees [1] which are not subject to underinsurance.

Depreciation, as an optional cost, is a novel and innovative concept in Business Interruption insurance, has never been explored at all.

Introduction

This technical paper, Understanding depreciation in Business Interruption insurance — A misunderstood concept, is a study of the meaning, practice, process and application of depreciation as an optional Cost in the Business Interruption insurance. 

It is appreciated that the concept of depreciation as an optional cost is totally against the norm of the Business Interruption insurance practice and would likely face considerable challenges from all angles.

An open mind is what is required for an understanding of this concept of depreciation as an optional cost for the learning curve. 

The awakening that depreciation is an optional cost stemmed from an actual Business Interruption insurance claim dispute following a fire outbreak at a manufacturing plant complex managed by a public listed corporation (the Claimant) against the Underwriter (the Respondent) under a Business Interruption insurance policy (the BI policy). It was arbitrated by a three-man arbitral Tribunal [2] (the Tribunal) whose Award was in favour of the Claimant, 

For reasons of confidentiality and privacy, the identities of the parties and Tribunal members as well as the date of fire and location of the palm oil mill could not be divulged. 

In a nutshell, the Tribunal, after hearing lengthy and protracted testimonies of expert witnesses and reviewing voluminous documentary evidence including bundles of authorities, held ipso facto cognizance to the fact that depreciation is not a fixed cost [3] (hereinafter referred to as standing charge), for the purpose of the Gross Profit [4].

The short story is that by including depreciation to the standing charges, the rate of gross profit by definition would be inflated up to an unrealistic level which was not cogently reflective of the Business insured. For this purpose, depreciation was regarded as an item suitably located in the specified working expenses (“SWE”). 

It has to be mentioned here that an Arbitral Award [5] is a private alternative dispute resolution (ADR) settlement between the contractual parties in dispute and is not regarded as a stare decisis (legal precedent), notwithstanding due process of law had been fully complied with, throughout the proceedings, in accordance with the Malaysian Arbitration Act 2005 (Act 646) by three eminent jurists whose grounds of decision are worth its weight in gold.

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[1] Additional Increase in Cost of Working and Accountants’ Fees/Charges are actually Optional items insurable at the discretion of the Proposer/Insured.

[2] The Tribunal comprised a London-based practicing Queen Counsel/Senior Barrister who is also a Law Professor, a former Malaysian Court of Appeal judge and a former Malaysian High Court judge.

[3] Fixed costs and Standing charges are synonymous.

[4] Gross Profit comprised Fixed Costs (Standing Charges) and Net Profit.

[5] Similar decision on Depreciation was reached by the NSW CA in Mobis Parts Australia Pty Ltd v XL Insurance SE [2018]. see Ibid, 12